China Tells

(Beijing Review) “The wolf has finally come,” Mr. Liu, who studied finance overseas, sighed when he heard that international hedge funds might enter the mainland securities market on the heels of QFIIs (qualified foreign institutional investors).

For most Chinese, international hedge funds are still an unfamiliar concept, but in developed international financial markets they are the capital in command. The investment strategies of hedge funds have brought new concepts of money-making through speculation to the stock market. In the futures markets, transactions leveraged by hedge funds can magnify the volatility of commodity prices. In foreign exchange markets, hedge funds are the currency speculators that worry governments the most.

Today, international hedge funds have quietly entered the Chinese securities market. What impact will they have?

Invisible private capital

“The wolf arrived some time ago,” said a private fund manager. “The mere increase of the QFII quota did not satisfy the appetite of international hedge funds. Since 2001, a large amount of hedge fund capital has entered China through concealed channels, such as foreign trade settlements and the Hong Kong market, in order to gamble on the appreciation of the yuan. Today, their presence is actively felt in China’s stock and realty markets.”

“At present, the combined scale of all Asian hedge funds that might invest in China is approximately $20-50 billion,” estimated Zhang Yuewen, post-doctoral researcher at the Institute of Finance and Trade Economics of the Chinese Academy of Social Sciences.

Without doubt, the strong growth of the Chinese economy has provided international hedge funds with a hot investment destination. In the last few years, when real estate was red hot, international hedge fund capital invested in real estate in China. They hid behind private capital players in Jiangsu and Zhejiang provinces and secretly bought many high-end properties that they later sold at substantial profit when property prices skyrocketed.

Later, China’s financial reforms gave them more opportunities to create new wealth. The contrasts formed by China’s surging economy and its depressed stock market of the past few years prompted them to absorb Chinese stocks at low prices. A raging stock market will make 2007 another bumper harvest year for hedge funds.

Targeting stock index futures

Presently, the biggest attraction for international hedge funds coming to China is the imminent launch of stock index futures. Using stock index futures to conduct arbitrage is their specialty.

“We find that international hedge fund capital is the supporter behind many private equity funds in China,” said Chen Lin, a researcher with Guosen Securities Economic Research Institute. “They have been waiting for the birth of financial derivatives trading products, such as stock index futures, which form the perfect stage for them to flex their muscles.”

Studying how foreign hedge funds manipulate stocks, seeing that if they bought a stock at 10 yuan a share, they would also buy the put option (the option to sell at a fixed price and time) on the same stock. Assuming they bought the put option for a stock at the exercise price of 9 yuan, if the stock dropped to 8 yuan, they would sell their stock at 9 yuan to minimize loss.

Hedge funds can avoid risks through hedging transactions, and also conduct arbitrage based on the same principle.

The simplest method is to utilize the short-selling mechanism of forward stock index futures to sell at a high price to make a profit. Assuming the Shanghai and Shenzhen 300 Index is at 3,000 points. If the international hedge funds use the stock index futures instrument and buy 1,000 options that are to be sold in September at 5,000 points of the Shanghai and Shenzhen 300 Index, then they would buy large volumes of the corresponding shares or index funds in the spot market between 3,000 and 5,000 points for harvest in September. At the same time, they must use good news to push the Shanghai and Shenzhen 300 Index above 5,000 points before September arrives. By then, the hedge fund can sell all shares bought in the Shanghai and Shenzhen stock exchanges and lock in large profits by fulfilling the 1,000 stock index futures options. Then, due to heavy selling by the hedge fund, the Shanghai and Shenzhen 300 Index is likely to drop drastically, causing losses to those “uninformed” copycat investors who chase rising stocks.

International hedge funds can also use the component stocks inside stock index futures categories to conduct forward transactions and earn profits. For example, if they believe a stock is overvalued, they would borrow large volumes of the stock from institutions such as the QFII and sell out. After carefully calculating the corresponding drop in the futures index following the drop of this stock, they would also buy the corresponding stock index futures call options. In the event the stated stock is dropping and actually drags the corresponding futures index to the expected level, the hedge funds would buy back the corresponding volume of this stock at a low fixed price by fulfilling the stock index futures call contracts, return the shares to the QFII lender, make profits on the price difference (sell stocks at high prices and buy them back at low prices), and pay a percentage of profit to the lender of the shares.

“We should not underestimate the research and development capabilities of international hedge funds,” said Zhang Qi, researcher with Everbright Securities Research Institute. “Since hedge funds use stock index futures to conduct arbitrage, they have to pinpoint the best time to buy and sell, 

and accurately estimate the fluctuations of the future stock market. Therefore, they analyze in meticulous details all factors that might affect the movement of the stock market.”

“Normally, some research reports on future market trends published by hedge funds have prospective impact,” said Zhang.

Arbitrage style supports blue chips

“The profitability model of the Chinese stock market is relatively single-threaded,” said CITIC Securities Research Institute researcher Sun Shengquan. “In summary, it is selling high, buying low and profiting from the difference in stock prices.

“In the eye of international hedge funds, the idea of holding and waiting for a price surge has risks. If the market experiences systemic risks, most stocks will drop drastically. Unless the shareholders know about this ahead of time and sell the stocks in advance–otherwise they can only sit there, waiting to die.”

At the end of May, the Chinese stock market dropped substantially because of the sudden stamp duty increase. Many investors were trapped. This was an obvious example.

“The hedge funds will bring a completely different investment philosophy to the Chinese stock market,” said Sun. “That is, to make profit by utilizing the price differential among different financial investment instruments to conduct arbitrage and make a profit. Compared with the single profitability model of holding and waiting, this model is more capable of avoiding market fluctuation risks.”

The stock manipulation methods used by hedge funds are plentiful. For example, they believe stocks in the same sector with different performances provide huge arbitrage opportunities. Usually, they would purchase blue chips in a certain sector and concurrently short-sell poor-performing stocks in the same sector, at a specific ratio.

If the sector performs as well as expected, the price increase of blue chips will certainly exceed other stocks in the same sector. The benefits in buying blue chips will more than compensate for the loss in short selling the poor-performing stocks. If the forecast was wrong, the decrease in poor-performing stocks will certainly be bigger than the decrease in blue chips. In this case, the profit from short selling will more than compensate for the loss in the drop of blue chips. This is another risk-free arbitrage trick pursued by hedge funds.

“This operating mindset will have profound influence on the trend of the entire stock market in China,” said Zhao Min, a fund manager at Huaan Fund Management Co. Ltd. “As more and more hedge funds enter the Chinese stock market, blue chips will be courted continuously while poor-performing stocks will be dumped. The future polarization of individual stocks will be unavoidable. By the same token, as seen in the development track of foreign mature markets, when institutional investors such as hedge funds become the main participants of the stock market, 20 percent of the blue chips will account for a big chunk of the stock index, and 80 percent of stocks that perform poorly will have little impact. The stock selection strategy of the hedge funds has very important effects on market polarization.”

In line with international markets

Cross-border arbitrage transactions are another “catalyst” fuelling the entry of international hedge funds into China. At present, international markets have a few China stock index futures: the FTSE/Xinhua China 25 Index futures listed on the Hong Kong Stock Exchange, the CBOE China Index futures on the CBOE Futures Exchange and the SGX FTSE/Xinhua China A50 Index Futures on the Singapore Exchange.

Following the entry of international hedge funds in the A share market, the once severed trans-regional arbitrage “link” has been quietly repaired. Using the simplest method, if the price of the corresponding domestic stock index is higher than the overseas China stock index futures, the funds would sell the index products domestically and buy the overseas China stock index futures products to earn the price differential. The converse is also true.

Using the time differential to conduct arbitrage is also a survival tactic of international hedge funds. As the Chinese stock market and international financial markets become more and more integrated, the price differential of financial products in the same sector will automatically become consistent. If the futures price of copper drops during the London trading timeslot, the opening price of copper during the Shanghai timeslot the next day should be low. If the Dow Jones increases the day before, the opening price of the Hang Seng Index in Hong Kong the next day should be high correspondingly. International hedge funds are fully capable of conducting arbitrage, utilizing the time differentials in different regions of the world and the interrelated influence of different prices of the financial products.

For example, an international hedge fund may purchase an A-share stock in the nonferrous metals sector, heating up the global futures prices of nonferrous metals overnight. When the global copper and aluminum prices increase, the prices of nonferrous metal stocks in China will usually rise the next day. Then, the international hedge funds can reap huge profits from stock investments.

“When an international hedge fund enters China, it will first target some index funds and closed-end funds,” said Sun. “Their stock composition is similar to the overseas China stock index futures products. As hedge funds usually use leveraged transactions, the size of the capital is multiplied. Once they discover a certain arbitrage opportunity across boundaries, they will engage heavily in buying and selling domestic indexed financial products to maximize profits, causing more fluctuations in the Chinese financial market.”

Strict government controls

“A large portion of the hot money we are familiar with is capital from international hedge funds,” a private equity fund manager divulged.

“From the standpoint of some governments, the damaging power of hedge funds toward international financial stability is severe,” said Wu Pengfei, a researcher at Guotai Junan Securities Research Institute. “But, since their actions are concealed, the financial regulators of many countries are unable to track them and take preventive actions. We have to guard against international hedge funds entering China and making waves in the market.”

As hedge funds get bigger and bigger globally, their impact on the economy is more profound. The task of regulating hedge funds is also getting more attention.

At present, there are close to 10,000 active hedge funds with assets totalling approximately $1.5 trillion. The United States and Britain, where the majority of these hedge funds are based, advocate risk control through dialogue and maintaining vigilance, particularly through the strictly regulated investment banks to “indirectly regulate” the hedge funds. On the other hand, Germany seeks more direct regulation of hedge funds.